The Internal Revenue Service (IRS) can file a lien and levy on any and all of a taxpayer's property (and rights to property) regardless of how the property is held or titled. 26 U.S.C. § 6321. Whether the item is a taxpayer's property is a subject of continuous and contentious litigation between third parties and the IRS.
Generally, a taxpayer's property rights are a matter of state law. Once it is found that a taxpayer has a state-created interest in property, federal law takes over. However, sometimes whether a state-created interest exists is blurred, which was the precise situation in Goodrich v. USA, 125 A.F.T.R.2d 2020-1276 (W.D. La. 2020).
Background
Henry Goodrich (Henry) died owing a significant amount of federal income taxes. Prior to his death, Henry held a usufruct, which is akin to a life estate and was created by his deceased wife's will that included personal property, real property, stocks and stock options (collectively, the "stock"), cash and mineral interests. Unlike the personal property, real property and mineral interests, Henry sold the stock during his lifetime.
Henry's three children (collectively, the "children") were the "naked" owners of the property subject to Henry's usufruct. Upon Henry's passing, the executor of the estate sold the real and personal property and deposited most of the proceeds in a bank account (the "estate's checking account") that was originally funded by the closing of Henry's bank account, which Henry funded in part by the sale of the stock.
A few years after Henry died, the IRS issued levies against funds in the estate's checking account, including cash that Henry received when he sold the stock. The IRS applied the seized funds to Henry's income tax liabilities, and the children filed a wrongful levy claim under 26 U.S.C. § 7426 in the U.S. District Court for the Western District of Louisiana.
The District Court held that the personal property, real property and proceeds from the mineral interests were property of the children pursuant to the usufruct; therefore, the IRS levy was invalid. The District Court further held that the usufruct entitled the IRS to possess the proceeds from the stock sale; thus, the IRS levy was valid.
Wrongful Levy Claim Under Section 7426
To establish a wrongful levy claim, a third party must demonstrate (1) that the IRS filed a levy with respect to a taxpayer's liability against property held by the non-taxpayer third party, (2) the rights of the third party in the property are superior to the rights of the IRS and (3) the levy was wrongful. Oxford Capital Corp. v. United States, 211 F.3d 280, 283 (5th Cir. 2000).
To prove that a levy is wrongful, (1) the third party "must first show some interest in the property to establish standing, (2) the burden then shifts to the IRS to prove a nexus between the property and the taxpayer, and (3) the burden then shifts back to the plaintiff to prove the levy was wrongful, e.g., that the property in fact did not belong to the taxpayer." Id.
Property Rights
In United States v. Craft, 535 U.S. 274, 276 (2002),1 the U.S. Supreme Court considered whether federal tax liens imposed pursuant to 26 U.S.C. § 6321 may attach to property owned by a delinquent taxpayer and his or her spouse as tenants by the entireties. The Supreme Court began by describing the different roles of state and federal law in determining what constitutes property for tax lien purposes (citations omitted):
Whether the interests of respondent's husband in the property he held as a tenant by the entirety constitutes "property and rights to property" for the purposes of the federal tax lien statute, 26 U.S.C. § 6321, is ultimately a question of federal law. The answer to this federal question, however, largely depends upon state law. The federal tax lien statute itself "creates no property rights but merely attaches consequences, federally defined, to rights created under state law." Accordingly, "[w]e look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer's state-delineated rights qualify as 'property' or 'rights to property' within the compass of the federal tax lien legislation." Id. at 278
Accordingly, for attachment to occur, the target property must be subject to the tax lien statute. United States v. Rodgers, 461 U.S. 677, 680 (1983). However, "the federal tax lien statute ... creates no property rights but merely attaches consequences, federally defined, to rights created under state law." Craft, 525 U.S. at 278. Once the tax lien has attached to the taxpayer's state-created interests, federal law determines the outcome. Aquilino v. United States, 363 U.S. 509, 513-14 (1960). As to state-created interests, federal courts shall be bound by the property law decisions of the highest court of a state. Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), citing to Erie R.R. Co. v. Tompkins, 304 U.S. 64 (1938).
Usufruct Under Louisiana Law
In Goodrich, Henry was the usufructuary. A "usufruct" is a right in a property owned by another, normally for a limited time or until death. Simply stated, it is the right to use the property, to enjoy the fruits and income of the property, to rent the property out and to collect the rents, all to the exclusion of the underlying real or "naked" owner. The rights of a usufructuary "vary with the nature of the things subject to it as consumables or nonconsumables." La. Civ. Code Art. 535.
Pursuant to La. Civ. Code Art. 536. "[t]he usufructuary becomes the owner of consumables, such as money, and may consume or sell them as he sees fit. As to consumable things, La. Civ. Code Art. 538, "[a]t the termination of the usufruct he is bound either to pay to the naked owner the value that the things had at the commencement of the usufruct or to deliver to him things of the same quantity and quality."
Nonconsumable things – such as lands, houses, shares of stock, animals, furniture and vehicles – are those that may be enjoyed without alteration of their substance, although their substance may be diminished or deteriorated naturally by time or by the use to which they are applied. La. Civ. Code Art. 537. However, "[h]e is bound to use them as a prudent administrator and to deliver them to the naked owner at the termination of the usufruct." La. Civ. Code Art. 539.
"The usufructuary may not dispose of nonconsumable things unless the right to do so has been expressly granted to him." La. Civ. Code Art. 568. Henry's wife expressly granted to Henry, in her will, the right to dispose of nonconsumable things. As to the stock, Henry exercised that right.
Property Other Than Stock Proceeds: Nonconsumables
The U.S. government generally agreed that the children were entitled to their interests in nonconsumables (i.e., mineral rights and certain personal property) under Louisiana law. However, the government claimed that because funds were deposited into the estate's checking account and were thus commingled, the funds could not be traced to the disputed funds. Thus, the government submitted that the children could not identify the disputed funds and therefore it was entitled to the funds.
The District Court quickly disposed of the U.S. government's argument, noting that it was based on another non-binding circuit court's opinion2 and that the children's records were sufficient. The District Court then applied the law of usufructuary as to nonconsumables and found that the children were entitled to the funds derived from the nonconsumables.
Stock Proceeds: Consumables
The children and the U.S. government relied on a treatise3 to interpret Louisiana law as to the usufruct's consumables. The children argued that the termination of a usufruct resulted in the "reintegration of ownership" and the "restoration" of full ownership or perfect ownership. That is, when Henry sold the stock, the usufruct terminated as to the stock and attached to the proceeds received from the sales.4
The government alleged that the children merely had an unsecured claim against Henry's estate as to the stock proceeds and were not actual owners of any particular cash. The U.S. relied on the same treatise albeit different sections.5 In addition, the government cited to four cases in support of its position.6
The District Court found In Re Succession of Catching to be persuasive.7 Accordingly, the District Court found that the children had a claim against the estate with respect to the cash Henry received for the stock but did not immediately become the owners of any particular cash at the moment of Henry's death. The obligation to the children was a debt or obligation of the estate that was subject to administration and payment only upon completion of the succession with adequate funds available to satisfy the obligation. The children's claim was, therefore, in the nature of unsecured creditors of the succession with respect to this claim.
Following the District Court's decision, the estate and the children filed a timely appeal in the U.S. Court of Appeals for the Fifth Circuit.
Fifth Circuit Opinion
In an opinion issued on July 6, 2021, the Fifth Circuit disagreed with the District Court's proposition that, as to a usufruct, In Re Succession of Catching and the Louisiana Civil Law Treatise were dispositive of the property interest issue. See Goodrich v. USA, ---- F.3d---- (5th Cir. 2021)
However, in agreeing with the plaintiffs-appellants' observation, the Fifth Circuit noted that Louisiana courts (including the Louisiana Supreme Court) have not "decided the precise issue of whether the naked owner of [money] occupies the status of owner or creditor." Accordingly, and to "avoid making ... a guess as to how the Louisiana Supreme Court would address the issue," the Fifth Circuit invoked a Louisiana Supreme Court rule to certify the following questions to the Louisiana Supreme Court:
- Does a usufructuary's testamentary usufruct of consumables render naked owners unsecured creditors of the usufructuary's succession?
- If not, what is the naked owner's relationship to those consumables?
The decision means that the IRS' ability to retain the levied funds will depend on the Louisiana Supreme Court's interpretation of state law as to usufructs.
Conclusion
Thus, the Fifth Circuit held that treatises and lower state court decisions are not dispositive of state property rights. Rather, that is a decision reserved for the highest court in the state. Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
Accordingly, Goodrich serves as a reminder that when analyzing the legitimacy of an IRS lien on property (and rights to property), it is wise to remember the basics: State law determines the property interest, and the property right can be defined by the state's highest court. If the property right has been decided by the state's highest court, then federal law applies; if not, then the individual's property interest may need to be determined before a wrongful levy action can be commenced.
Notes
1 In Craft, the Supreme Court addressed the issue of whether federal tax liens can attach to property owned in tenancy by the entirety by the delinquent taxpayer and his unindebted spouse. The Supreme Court ruled that the tax lien does attach to the property.
2 Bregman, Berbert & Schwartz, L.L.C. v. United States, 145 F.3d 664 (4th Cir. 1998)
3 3 A.N. Yiannopoulos, Louisiana Civil Law Treatise.
4 See 3 La. Civ. L. Treatise, Personal Servitudes §6:16-§6:18 (5th Ed.).
5 See 3 La. Civ. L. Treatise, Personal Servitudes ["A usufruct of consumables differs from a usufruct of nonconsumables because the usufructuary acquires ownership of the things and the naked owner becomes a general creditor of the usufructuary." § 1:3 at 9. "When the usufruct terminates by the death of the usufructuary, the debts that the usufructuary owes the naked owner, including restoration of the value of consumables that were subject to the usufruct, are debts of the succession." § 6:18 at 400 n. 2.].
6 Succession of Majoue, 705 So.2d 225 (La.App. 5th Cir. 1997); Succession of Catching, 35 So.3d 449 (La.App. 2nd Cir. 2010); Succession of Dittmar, 493 So. 2d 221 (La.App. 5th Cir. 1986); Succession of Feingerts, 162 So.3d 1215 (La.App. 4th Cir. 2015), writ. denied, 171 So.3d 936 (La. 2015).
7 In Catching, the court "cited jurisprudence that stated the obligation of the usufructuary in such cases "is in the nature of a debt owed by the succession to the owners." The court held: "The usufruct terminated upon James' death and became a debt owed by the succession to the naked owner." See Catching, 35 So.3d at 451.
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